ICBA Bancard - Bancard Confidential

A Perspective on the Durbin Amendment

The Conference Committee on Wall street reform legislation made significant changes to the amendment originally adopted by the senate. While the key provision—the regulation of debit interchange by the Federal Reserve—still remains, the significant changes are summarized below:


•	The Federal Reserve is tasked with setting debit interchange rates in a manner that is “reasonable and proportional” to the transaction.
•	The Fed has the ability to consider fraud costs in this calculation, but does not appear to be able to consider operational costs.
•	Issuers are obligated to prevent fraud and comply with a new set of regulations to be issued by the Fed on fraud.
•	Issuers under $10 billion in assets are “carved out;” however, ICBA maintains this exemption will not prove meaningful as these provisions are implemented in the marketplace.
•	The “honor-all-cards” rule was strengthened to reduce the ability of merchants to discriminate against community bank-issued credit and debit cards.
•	The provision allowing merchants to impose minimum dollar amounts for credit card acceptance was capped at $10, and the maximum dollar amount provision is limited to federal agencies and institutions of higher education.

By Lee Manfred

Editor's Note: The following editorial is based on the original Durbin amendment submitted to the Senate.

On May 20, the Senate approved its version of the Financial Regulatory Reform bill which included the Durbin Amendment, a late addition to the bill that could bring profound change to the payment card industry in the U.S. The Durbin Amendment is a clear victory for merchants and a setback for issuers and payment networks. The extent of that victory or setback will depend on the reconciliation with the House bill and then how the Fed ultimately decides to implement its provisions. As drafted, however, the Durbin amendment is an example of bad lawmaking on many levels. First, its attachment to the FSR bill is clumsy at best in that it deals with a business controversy unrelated

to the financial crisis the bill is intended to address. Second, the Durbin Amendment is simplistic, failing to consider the many complexities inherent in the long-running controversy between merchants and the payment networks/banks. Most importantly, the amendment does not contemplate any of the negative unintended consequences it will likely have on most stakeholders, including many merchants.

Problems and Ambiguities

The amendment's language has a high degree of ambiguity in some areas, and overly broad definitions in others. Below we highlight some of the provisions that are problematic including areas where the Fed will have difficulty in establishing a practical set of final rules.

Scope. Part 1 - While touted as interchange regulation, the amendment discusses "issuer and network interchange transaction fees," which could be read to apply to network switch fees and assessments, as well as issuer interchange revenue. Network access fees (i.e., those fees paid by banks to payment networks) have been intensely competitive for years, so their inclusion in this amendment is puzzling.

Scope, Part 2 - The amendment lumps all debit cards into one category, "whether authorization [is] based on signature, PIN, or other means." This language suggests that all debit and prepaid cards should receive the same interchange, even though they target different customer needs and have different features and attributes.

Cost, Part 1 - The language is fairly detailed in defining costs as "incremental," and attributable to a particular transaction, and excluding costs not specific to a particular transaction. That said, a 2007 STAR Network study of issuer costs, performed by First Annapolis, showed that the average cost of a signature debit transaction was $0.228, while the average cost of a PIN debit transaction was $0.103. More importantly, some issuers had costs three times or more higher than others. Given this huge disparity in costs, the definition chosen by the Fed has the potential to unfairly enrich efficient issuers, while penalizing higher cost issuers.

Cost, Part 2 - Irrespective of debit card type, transaction costs also vary widely based on the type of merchant at which the purchase is made, due to a variety of factors including the POS environment, retail channel, nature of the goods sold, transaction size, fraud exposure, return/dispute profile, and many others. If the cost is to be attributed to a particular transaction, then each of these factors would appropriately be considered in determining if the fees are reasonable and proportional. The logical outcome is an extremely detailed and potentially unwieldy schedule of fees that will likely still contain inequities within and across merchant segments.

Cost, Part 3 - In limiting the scope of costs considered to incremental costs, the bill fails to address the cost of building, developing, and maintaining the network itself. Absent the financial incentive to do so, banks and networks (and any for-profit entity) have no incentive to make future investments in payment system efficiency and innovation.

Considerations - The bill requires the Fed, in issuing its rules, to consider "the functional similarities between electronic debit transactions and checking transactions that are required within the Federal Reserve Bank to clear at par." At first blush, this provision seems to call for a very low interchange fee, i.e., close to par. Perhaps naively, it can also be read more optimistically by card issuers and networks, as requiring the Fed to consider the similarities and differences between debit cards and checks. There are real and material differences-guaranteed payment, cross-border utility, no NSF checks, network fraud screening, shorter tender time, increased efficiency, consumer preference, and the like-and the Fed should consider all of the qualitative attributes of debit payments in issuing its rules. Further, the Fed should consider fully merchants' costs of check acceptance in evaluating this issue.

Profit - Profit is a term never used in the amendment. Price, and by extension, profit, is usually a function of three factors: cost, competition, and as discussed in the previous paragraph, value. This amendment, however, only considers cost. In a free market system, governments should not be the arbiters of "reasonable and proportional" profits.

Potential (Maybe Likely?) Outcomes:

The Durbin amendment is fraught with the potential for unintended consequences, for all affected stakeholders:

Consumers: The intended beneficiaries of this legislation (although we should acknowledge it is about punishing the banks for the financial crisis) will likely emerge losers in the transition. They are customers of both retailers and banks. As such, the transfer of price from bank to merchant is unlikely to create a net benefit to consumers. In all likelihood, consumers will pay more for banking services in explicit fees, as banks attempt to recoup lost interchange revenue, possibly in amounts greater than any retail price declines. One needs to look no further than the CARD Act to witness the upward pressure on the cost of credit to certain consumers and the contraction of credit to others. Depending on how merchants and banks respond, consumers may experience confusion and frustration at the point of sale, where merchants may differentiate prices based on tender type, reducing consumer choice. Additionally, rewards programs on debit cards will likely disappear with reduced issuer revenue. Finally, fringe consumers may also experience reduced access to mainstream financial services, as banks are forced to implement explicit account fees for services to replace lost revenues, pricing some marginal customers out of the traditional banking system.

Small banks: While exempted from the provisions, small banks will likely suffer under the new rules. While theoretically they can receive higher interchange, they could lose on two fronts. First, their costs are higher, so their margins could remain lower than those of big banks, depending on how "actual cost" is determined. Second, as networks compete for merchant acceptance, the fee paid to small issuers will encounter downward pressure, until it equals that of large banks.

Merchants: In the spirited debate over interchange, merchants have consistently argued the low cost of accepting cash and check relative to debit cards. This argument will be tested to the extent banks reduce the promotion of debit cards, networks shift investment priorities in network development and utility, and if consumers have restrictions on the payment forms they prefer. Small merchants may be further disadvantaged; while acceptance costs may be reduced in total, the cost disadvantage they suffer relative to major merchants is not addressed by the bill.

Processors: No matter how the debit interchange landscape is changed, processors will be forced to implement the changes in a 90 day window. These innocent bystanders of the interchange battle are unlikely to recoup the cost of these changes from their issuer, acquirer, and merchant customers.

Legislators: While "big government" is in vogue, price controls such as those proposed in the Durbin amendment often create market inefficiencies. Limiting the promotion, acceptance, and investment in electronic payments increases the risk of a less efficient payment system, with all its attendant costs. In the context of a reform bill intended to address the causes of the financial crisis, this amendment ironically continues the legislative agenda of limiting or eliminating important bank revenue streams.

The Durbin amendment attempts to address incredibly complex and controversial issues in about a thousand words. Political leanings aside, a hastily drafted and implemented law brings untenable systemic risks, along with potentially unintended outcomes.